Talk about a 180. After a dismal year, the bond market is rallying as investors celebrate the likely end of the Federal Reserve’s historic interest rate tightening cycle.
After peaking at roughly 5% in mid-October, the yield on the 10-year Treasury note has fallen to 4.26%. Meanwhile, the Morningstar US Core Bond Index has returned 4.3% over the past month. As a result, the index is up 2.2% so far in 2023.
These gains mark a major reversal. Just two months ago, the Core Bond Index was flirting with an unprecedented third straight year of declines as yields surged to their highest level since 2007, thanks to an unexpectedly resilient economy. “People are surprised by the speed with which the narrative has shifted,” says Kelsey Berro, a fixed-income portfolio manager at JPMorgan Asset Management.
Why Are Bonds Rallying?
“We’ve seen in big shift in both sentiment and positioning,” Berro explains. Over a month, investors have transitioned from believing the Fed might need to hike rates even further to betting that the central bank is finished. Now, she says, “everyone is trying to time when the first rate cut is going to happen.”
Strategists credit a myriad of factors for the turnaround, including a moderating labor market, increasingly dovish discourse from the Fed, tightening lending standards, and forecasts for a much milder GDP report in the fourth quarter compared with the third quarter’s blowout reading. In other words, investors finally have a sense that the Fed’s policy tightening is catching up with the economy and cooling things off. Not to mention the inflation rate finally slowing down. “We’re quickly closing in on [the Fed’s] 2% target,” Berro says. And while we’re not quite there yet, markets are “anticipating future progress.”
It’s no wonder bond traders are optimistic. “All that seems to be coming together, and markets are quickly pricing it in,” says Jack McIntyre, a portfolio manager for Brandywine Global.
Traders Look Ahead to Rate Cuts
Bond traders now expect the Fed to cut rates at its March meeting, according to the CME FedWatch Tool. In total, bond futures markets are pricing in 1.25 percentage points of easing by the end of 2024, or five separate rate cuts of 0.25% each. That would take the federal-funds rate down to a target range of 4.00%-4.25% from its current target range of 5.25%-5.50%.
McIntyre warns that these types of market predictions can be fickle, since traders’ expectations about rate cuts and hikes ultimately depend on economic data (just like the Fed’s decisions). “It’s a little bit of a whipsaw,” he says.
Can the Bond Market Rally Continue?
Analysts at UBS are forecasting that the 10-year US Treasury yield will drop to 3.5% by the end of 2024, according to a Friday research note. They point to cooling inflation and labor market data that they believe will likely allow the Fed to start cutting rates in July. But headwinds remain. “We’ve got a whole bunch of potential landmines,” McIntyre says, pointing to upcoming jobs and inflation data and the last Fed meeting of the year.
Berro acknowledges that the bond market can be volatile: “I wouldn’t rule out the potential that [yields] could move a bit higher over the short term.” There’s also a risk that the Fed doesn’t cut rates in March like traders expect, which could push yields up. That said, she believes “risks are biased toward lower rates.”
Despite the potential for wide swings in prices, for bond investors, it’s still a better environment in which to own fixed income than before the run-up in yields.
“Bonds are back to paying income,” McIntyre says, even amid volatility and even if that income is just the bond’s coupon without any price appreciation at all. “I actually think [investors will] make money on owning bonds next year.”
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.